COOP reported solid and relatively uneventful Q3 results last week – this post will provide a quick review and update.
Quarterly operating cash EPS was incredibly strong at $1.80/share. As a reminder, this figure is burdened for amortization of the embedded MSR fair value gain, so it correctly reflects a reasonable estimate for the current economic cost of replacing servicing runoff. Mortgage rates again declined in Q3 (~10bps), although the pace has slowed considerably vs. the first half of this year. Refinancing volumes remained well above-trend, further exacerbating what was already an incredibly tight supply/demand backdrop. The industry was reducing headcount and capacity entering this year (see pages 55-56 of my original presentation), so most lenders remain caught off-guard at 2019’s refi wave. This environment produced very strong origination volumes and margins, however this was somewhat offset by higher amortization in the servicing segment (17.5% CPR vs. 11.1% last year).
Although the rate-driven industry environment remains volatile, COOP continued to execute well on factors within its control. The company continued to harvest Project Titan savings, mitigating the rate-driven margin pressures in the servicing segment. In the Xome segment, management continued the successful integration of the AMS acquisition and drove AMS margins above breakeven levels. The AMS integration has taken longer than expected, however it should now begin contributing positive operating earnings going forward.
After years of high growth and acquisitions, management recently pivoted to focusing on integration, efficiencies, and de-leveraging. Project Titan successfully addressed various legacy servicing inefficiencies and management is now turning to address excess overhead at the corporate level. Cost cutting is underway and management expects another $50mm in savings from these activities.
On capital allocation, the current priority remains corporate debt de-leveraging – I agree with this focus. The complexity of COOP’s business and accounting will always create a barrier for many public market investors, however addressing the high leverage levels – an additional hurdle for investors – is within management’s control. Leverage declined to 4.1x on an LTM basis, comfortably below management’s 5.0x target, however this metric is flattered by the current excess profits in the originations segment. This isn’t a bad thing, however, as management is opportunistically utilizing this excess FCF production to accelerate debt retirement. Management has already called $100mm of 2021 notes following the quarter, and expects to address most of the residual 2021 notes (~$500mm) during 2020.
In many ways, it’s amazing how much the investment thesis has evolved since my first COOP post. In my original presentation, I was laboriously arguing that COOP’s current earnings (~$0.75/share in 2018) significantly understated the company’s medium-term earnings power of ~$3.50-$4.00/share. And after only a few quarters, investors are now debating how much COOP is currently over-earning in today’s tight refi environment. In less than a year, the company went from earning too little to earning too much! The stock has done well during this transition, however I continue to think today’s stock price incorrectly discounts where run-rate earnings should settle out.
For perspective, COOP has earned ~$3.55/share of adjusted operating earnings YTD, so 2019 earnings should easily be $4.50+. If you normalize for lending volumes and margins that are currently above midcycle, I think COOP loses ~$1.75/share of excess lending profits (this assumes normalized margins of ~90bps on ~$30bn of volumes). Offsetting this headwind, we should see ~$0.50 of recently identified corporate savings, ~$0.40 of interest savings from paying down the 2021 notes, another ~$0.35 of interest savings from subsequently refinancing the remaining high cost corporate debt (assuming ~1.5-2.0% blended savings), and ~$0.10 from AMS upside. Netting everything together, we have line-of-sight on ~$4.10+ of run-rate cash EPS, modestly above my original presentation estimates.
So despite COOP’s strong recent performance (+40% from my original post), (i) we have much better visibility on COOP’s run-rate earnings generation, yet (ii) the stock is still trading at a punitive ~3.0-3.5x midcycle earnings. What gets the stock to work? I think the balance sheet will be in good shape following the 2021s retirement (<4.0x leverage), arguing that COOP’s substantial FCF generation can finally be diverted towards share repurchases in 12-18 months. High leverage levels have constrained management’s ability to return capital for several years, so I don’t expect the stock to get credit for this until a buyback is formally announced. Once a buyback is on the table, however, the current valuation doesn’t make sense – at the current price, the company could responsibly and sustainably buy back ~30% of its float per year.
In summary, I continue to find COOP extremely compelling at current prices. The stock is higher today, however the visibility on the investment thesis is also much clearer.